One of the newest firms looking to expand the universe of pension liability buyouts is London-based Paternoster, which received regulatory approval to start operations in June 2006. The firm had its first transaction on Aug. 9, 2006, taking over the pension assets of the Cuthbert Heath Family Plan in a deal said to be worth about £10 million. Paternoster’s chief executive officer, Mark Wood, cites many reasons for plan sponsors to take pension liability buyout funds seriously, particularly as a response to the increasing regulatory burden worldwide that is making DB pension schemes untenable for many employers. Nowhere is the regulatory crackdown on pension accounting having more of an affect than in the U.K., creating an environment that is ripe for the kinds of pension liability buyout proposals insurers such as Paternoster are offering. Wood says new rules forcing no-holds-barred disclosure of all pension liabilities on company balance sheets and the topping up of DB plan liabilities is one reason. Another is a new levy to support the newly created Pension Protection Fund, which DB plan sponsors will soon have to pay into. Combined, these factors are running up the costs of having a pension fund while driving more and more to consider whether or not the whole DB system is worth supporting.
Another issue that’s upping the ante for DB plan sponsors—people are simply living a lot longer. Life expectancy rates are headed up and, as such, so are the costs of payouts during retirement. “These factors are all increasing the cost of running defined benefit plans and causing companies, in general, to ask ‘how do we mitigate the risks of these schemes costing significantly more than we’d expected,’” says Wood. “Clearly, buying out a pension scheme and transferring it to an insurance company absolves trustees of their responsibility.”
In return for a one-off payment, which includes paying the deficit as well as a lump sum payment to the insurer for its services, plan sponsors can wind up the plan on their balance sheet and completely offload all the pension risk and further payments to another party. So as markets rise and fall and life expectancy keeps increasing, the plan sponsor won’t have to worry about those added costs dragging down the company’s performance.
In a world where companies are being driven to prove their value to shareholders, pension liability buyout schemes can be hugely appealing. Think about the unflattering description given to General Motors in recent years: a pension fund and healthcare provider that happens to make cars. GM’s chief executive officer, Rick Wagoner, didn’t mince words when he said, “Our legacy costs in pensions and healthcare are an area of significant competitive disadvantage for us.” Says Wood, offloading pension liabilities is particularly good for companies in sectors such as the automotive industry, where years of restructuring and re-engineering the way they do business has been key to keeping pace with an evolving marketplace. “If you look at the auto industry,” Wood explains, “a lot of manufacturing has been outsourced or offshored, and yet the pension liabilities for jobs that used to exist in the corporation are still on the balance sheet. Part of that restructuring has been left unattended and buying out the pension liabilities removes the last element of risk and completes the re-engineering process.”
But while the pension liability buyout market in the U.K. is mainly limited to the many firms with legacy plans in that country, Ian Markham, director of pension innovation with Watson Wyatt Worldwide in Toronto, agrees that some day, pension liability buyout funds might just help companies with continuing DB plans keep their credit rating up. “Analysts might mark companies down due to pension risk on a balance sheet. It may be that we see some marking down of credit rating for companies that have massive pension plans with massive risk,” he explains. Looked at in this light, transferring that risk away looks attractive.
REALITY CHECK
Overall, business for liability buyout firms appears to be off to a sluggish start and some believe the size of the deals hasn’t lived up to the initial media hype that surrounded the launch of U.K. buyout firms such as Paternoster and Synesis Life in 2006. For one thing, the deals appear to be quite small: Paternoster’s initial Cuthbert Heath deal was a modest £10 million and, more recently, it took over the Chartered Accountants’ Employees Superannuation Scheme in a deal with between £10 and £15 million. While these numbers are respectable, they are still far short of the estimated £900 billion pool initially envisioned by some.
Pension liability buyouts “aren’t the panacea people thought they would be when the hype came out,” says Dawid Konotey-Ahulu, a partner with London, U.K.-based Redington Partners. Plan sponsors need to first get rid of the deficit, and they also need to pay the insurer for its services. That means they need to have a lot of spare cash to fund the solution. A key factor behind the higher costs, says Konotey-Ahulu, is how the liabilities are calculated. For plan sponsors looking to shift their pension liability to an insurer, the costs will be much higher than the actual liabilities on the balance sheet because insurance companies use far more conservative calculations for life expectancy and return on investments. Hence, a buyout can cost more than just fixing the liability problem and keeping the plan on the books.
Trask agrees that the cost of buyouts is a lot higher than most companies can afford—and that’s been a barrier to growth for firms selling them. “The gap between the ongoing funding level and the buyout funding level is still enormous for most schemes,” says Trask. As a result, he explains, “I think it’s unlikely that all of the new firms in the market will meet their targets. To do that, the market would have to multiply by ten-fold over the next year or two. I’m not saying it won’t, but a buyout is a very expensive thing to do.”
So with the high costs involved in implementing a pension liability buyout, is it worth it? Steve Bonnar, a consultant with Towers Perrin in Toronto, says that only time will tell if the amount of press coverage garnered by pension liability buyouts early in 2006 will result in eventual interest from plan sponsors. Ultimately, the solution to DB plan woes really boils down to risk management—and that’s something plan sponsors are already getting a grip on. “If you ask why an organization would want to do a pension liability buyout,” Bonnar explains, “it’s really about organizations asking ‘how much risk should we be taking?’” While buyouts are one option, chief financial officers and trustees are quickly learning other ways to manage a DB plan so that it isn’t as big a drag on a corporate balance sheet. Says Bonnar, “Organizations are doing a better job of assessing the financial risk they’re taking in the plans.”
Indeed, there are other, less drastic steps DB plan sponsors can take to cope with the risk than going the buyout route. Konotey-Aluhu points out that tools such as bonds and derivatives are helping plan sponsors manage pension plan risk on their own, much more cheaply than a buyout. Says Konotey- Aluhu, “[Pension liability buyouts] should be seen as part of a larger toolkit for fixing the problems.”
BUYOUTS IN CANADA
While plan sponsors in the U.K. are working to fix the funding problem, plan sponsors in Canada are grappling with the same issues. So does that mean pension liability buyouts could make their way across the pond? Bonnar isn’t so sure. He says the demand just isn’t here right now. Even in terms of traditional buyouts targeting closed plans, Bonnar argues there just aren’t as many here in Canada as there are in the U.K. and even in the U.S.
He also believes that Canadian society is inherently more “paternalistic”—“we have a trend toward taking care of employees.” Markham is equally skeptical and believes that regulators wouldn’t be very supportive of pension liability buyouts. “Unless the plan sponsor is a distressed company, it’s hard to see regulators embracing this with enthusiasm,” he says. “It’s the idea of pushing off the liabilities over to some other related company that will take a profit from it. There would be a worry politically about the viability of the organization who bought the pension fund.”
Meanwhile, in the U.K., Wood is adamant that Paternoster is on track to meet its targets and, in fact, “the market is more buoyant than we anticipated.” While skeptics say the cost is set to remain a barrier for most companies, DB plan sponsors might just come around to the notion that removing the plan risk from the company balance sheet is worth it. And, for the right price, pension liability buyouts might just be the bit of magic they’re looking for.
Caroline Cakebread is the editor of Canadian Investment Review. caroline.cakebread@rogers.com
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